A Fundamental Misunderstanding of Risk
When it comes to investing, most people’s definition of risk is “How much can I lose in the short term?” While it’s understandable, it’s the wrong way to think about investing and causes the average investor to be too conservative. An investor that tries not to lose in the short term will find it hard to accumulate wealth and secure a comfortable financial future. The correct way to look at risk is to ask yourself, “Will I have the money I need to spend when I need to spend it?”
The stock market is a powerful tool for building wealth. In the last hundred years, its total return has averaged about ten percent a year but in the short term, its value can fluctuate greatly. Ten percent pullbacks are common, happening about two times a year. Thirty percent pullbacks happen every two to three years, and large dips of thirty to fifty percent happen every ten years or so. You don’t put money into the stock market that you plan to spend in the near future. However, over a long period of time, the stock market is the best place to invest for long-term security. You need to manage risk accordingly and we find a good visualization for managing risk is the Three Buckets Philosophy.
The Three Bucket Philosophy works like this. As an individual, you have three buckets for your money.
- Bucket 1 is for money you will spend quickly (0-2 Years)
- Bucket 2 is for intermediate-term money you will spend 2-15 years from now
- Bucket 3 is for money you are not planning on spending for 15 years or more. Here’s how it works:
(Short Term Money – Household Expenses, a new car in six months, or the down payment on a house in a year)
The risk for short-term money is that it won’t be there when you need to spend it. Since there is a short time until you must spend it, the funds need to be invested in very conservative investments that don’t fluctuate in value. A checking, savings, or money market account would be appropriate for Bucket 1 money.
(Intermediate-Term Money – College and Vacation Home Savings, Home Improvements, Income Enhancement)
You want Intermediate-Term Money to grow but there is a chance you will spend it in the next few years. You want more growth than a savings account can offer but don’t want the ups and downs of a 100% US Equity portfolio. This money should be invested in a well-diversified portfolio of Large and Small Cap Equities, Bonds and Fixed Income Investments, Real Estate, and Commodities according to your risk tolerance. The returns will be dependable but never exciting, and market downturns won’t cause you to lose sleep.
(Long-Term Money – Retirement – Wealth Creation)
The risk for long-term savings is not short-term fluctuations, it’s that you won’t have enough money to comfortably fund your expenses in future years. It is next to impossible to save your way to retirement using conservative investments. You will need 25 times your annual expenses to retire comfortably and it’s extremely difficult to build that kind of wealth by putting money into a savings account earning 1% interest. You must buy ownership stakes in America’s greatest companies and earn a portion of their profits. It may sound counterproductive, but with long-term money you look forward to dips in the market. Market pullbacks give you the opportunity to purchase more shares (a greater percentage of the company) for the same amount of money. Bucket Three money should be 100% invested in higher risk, higher potential return US Equity Investments.
As time goes on, you will move Bucket 3 Money to Bucket 2 and Bucket 2 Money to Bucket 1. The dividends earned in Bucket 2 should be used to replenish money spent from Bucket 1. Executed correctly, the Three Buckets Philosophy should provide the cash necessary to fund your spending needs throughout your life and beyond.